Margin Call: Can Alumni Lending Survive the Current Rate Environment?

In the last three years, there has been significant growth in the peer-to-peer lending space, particularly within the student loan segment.  While we applaud the entrance of new funding sources into the student loan market, there are increasing signs that some of these lenders might face challenges in the current interest rate environment.  These challenges stem from their use of market-based funding sources, rather than deposit funding sources like traditional banks.  Market funding, particularly through the use of “warehouse” credit facilities, can be particularly unstable because market lenders can demand more collateral against their loans as asset prices fall – what is known as a “margin call”.  If a borrower cannot provide additional collateral, typically within 24 hours, then the market lender can seize and liquidate the existing collateral in order to cover their lending position – a positive feedback loop that amplifies losses.  Traditional deposit holding institutions are insulated from this loop because they can hold their loans to maturity and fund them through both customer deposits and the Federal Reserve’s discount window.  While these traditional banks are still subject to bank runs and mark-to-market losses, they typically happen much more slowly than market based borrowers.

To demonstrate how this type of market based lending can go wrong; let’s take an example where the Student Lender uses alumni investment to fund a portion of their portfolio and borrows from a Market Lender for the remaining portion.  In this example, let’s assume that the Student Lender funds their initial portfolio with 20% alumni investment and 80% debt from a Market Lender.  Let’s further assume that the portfolio of loans has a fixed coupon rate of 6.25% and a maturity of 10 years.  So, for a $100 million portfolio, the Student Lender would use $20 million of alumni investment and $80 million of debt from the Market Lender.  If we assume that the Student Lender has accurately priced the risk of the loan portfolio, then we can determine the market value of the portfolio by calculating the spread over the equivalent Treasury security; in this case, the 10 year Treasury yield.  

Because the Student Lender’s portfolio has a fixed interest rate, the market value of the portfolio is subject to change based upon changes in the equivalent Treasury security; in this case, changes in the 10 year Treasury yield.  If 10 year yields go up, then the market value of portfolio will go down, because investors could readily achieve the same fixed rate return while buying less risky securities.  The figure below shows how the market value of the loan portfolio would change if the Student Lender had originated the loans in May of this year. 

There are a few very notable points in this figure.  First, we note that 10 year Treasury rates have increased from 1.75% on May 3, 2013 to 2.88% today – that is a very large and rapid increase by any historical standard.  Correspondingly, we note that the market value of the Loan Portfolio has fallen ~8% over that same timeframe; however, due to leverage the value of the alumni investment has fallen by almost 40%.  Even more notably, the ratio of Debt to Portfolio Value has increased significantly.  In the third set of rows, we outline a potential 85% Collateral Requirement; in other words, the Market Lender may stipulate that at no point can the ratio of Debt to Portfolio Value increase beyond 85%.  In order to rectify any imbalance in this ratio, the Market Lender could force the Student Lender to post greater collateral through a margin call.  We note that, under these assumptions, the Student Lender would be faced with a $1.6 million margin call at today’s rates.  If the Student Lender is unable to post that amount –within 24 hours of the request – then the Market Lender would seize the portfolio and liquidate it in order to recoup its investment, effectively wiping out the entire Alumni Investment.

Finally, in the last two columns we have forecasted out the same calculations based upon the prevailing assumptions for the 10 year Treasury yield.  As you will notice, the implications are not pretty for Alumni Investors: by March 2014 the Alumni Investors have lost nearly 60% of their investment and are facing a margin call of nearly $5 million.  Now, to be fair, if the Student Lender were a traditional bank then the equity investors in the bank would face the same market losses on their investment; however, they would be largely exempt from a potential margin call, which is the ultimate destabilizing factor in a market based lending system.  Further, from a borrower perspective none of this may matter: regardless of whether the Student Lender makes or loses money, the borrower has already locked in the terms of their loan and will be largely unaffected.  However, borrowers who sign up for alumni lending programs because of the social aspect of the loan product might find themselves in a sticky situation if those alumni start seeing their investments evaporate.

Who’s Had the Worst Week Ever? Pretty Much Everybody.

For most Americans, last week was probably a pretty normal week.  For those of us who work in the financial markets, however, last week was something of a nightmare.  For the past several years – since the Financial Crisis at least – the global financial system has been tepidly moving forward despite a growing number of economic concerns around the globe.  Last week, each one of those global concerns flared up into mini-crises that individually would cause concern, but in concert should cause alarm.  In this post, we're going to run through the top five events.

5.  Turmoil in Emerging Market Economies: Last week was a historically bad week for “Emerging Market” economies.  In particular, rising inflation in Brazil led to the largest displays of civil unrest in the country’s history.  Throughout Brazil, approximately one million citizens took to the streets to protest the government’s mismanagement of the Brazilian economy.  In India, the local currency (the Rupee) has lost 10% of its value against the US Dollar in the past two months, which is driving up the price of imported gold and oil and fanning already hot inflation numbers.  In South Africa there was a combination of both, as its local currency (the Rand) has seen an 11% drop in its value against the USD and widespread work stoppages have continued to plague South Africa’s mining entities who are already struggling with falling commodity prices.  

4.  European Sovereign Debt: Much to Germany’s chagrin, both Cyprus and Greece – those cradles of early European civilization – retook their place as ground zero for the EuroDebt Crisis.  It has become clear that Greece is heading towards a third default in as many years and last week brought the news that the IMF would pull its loan package unless the other European nations (pronounced “Germany”) kicked in an additional $3 billion of aid.  At the same time, the Cypriot president published a letter requesting to rewrite the terms of a bailout his party agreed to less than two months ago.  Any unwillingness on the part of the Germans to support additional bailouts could put either or both countries on a final course for leaving the Euro.  As these two relatively small nations move towards an exit, focus has returned to the other ailing EU states: Spain, Portugal and Italy.  Interest rates on Spanish 10 year bonds crossed five percent for the first time in almost a year, a rate that could threaten the sustainability of the country’s current debt burden. 

3.  Japan’s Great Abenomics Experiment: Over the past six months, Japan’s Prime Minister Shinzo Abe (pronounced “ah-bay”), has embarked on an aggressive economic campaign dubbed “Abenomics.”  Abenomics intends to produce inflation by converting a large amount of Japan’s enormous government debt into newly printed Yen in the hopes that it will spur Japan’s savers to start spending money in the economy.  The new policy has met with some inconclusive results, but has greatly increased the volatility in what has, for the last ten years, been a relatively stable market.  In particular, recent efforts to reform some of Japan’s more rigid employment practices have failed to gain traction in parliament.  As a result, the combination of a rapidly aging population, a growing energy import bill due to the shutdown of domestic nuclear power after the 2011 Tsunami, and troubling signs in China are continuing to raise concerns about Abe’s ability to ultimately slow the creation of new money and protect the Yen from massive inflation without any commensurate economic growth.

2.  Financial Turmoil in China: Since 2008, nearly all of the world’s economic growth has stemmed from China.  More specifically, it has stemmed from China’s massive government stimulus program, which has brought about the largest period of credit expansion the world has ever seen.  As the US learned in the run-up to the Sub-Prime Crisis, rapid expansion of credit is not always a perfect recipe for sustainable economic growth; and now China seems to be learning that lesson firsthand and on a larger scale.  This past week brought rumors (verifiable facts are scarce in China) that multiple Chinese banks had defaulted on short-term loans, which sent interest rates spiraling to over 25% - up from just 3% a month previously.  The panic stems from – stop me when this sounds familiar – the recent outgrowth within Chinese banks of investment products called “Wealth Management Products” or WMPs.  These WMPs function very much like short-term certificates of deposit, except that they invest in high risk real estate ventures, often backed by notoriously corrupt local Chinese governments.  It now appears that some – maybe most – of these WMPs were backing investment projects that carried far more risk than was initially advertised.  As a result, every time a WMP matures – roughly every 90 days – the bank is unable to repay investors with cash generated by the underlying investment and, instead, is forced to pay existing investors by…issuing more WMPs!  Most Americans might recognize this investment strategy as the old teaser-rate adjustable rate mortgage, where homeowners would take out mortgages they could not afford under the assumption that they would refinance before rates re-set to normal levels.  Or maybe you’d recognize it from Bernie Madoff’s criminal trial.  In either case, these WMPs have grown from a sleepy backwater in 2008, when there was just $300B worth of WMPs outstanding, to a major financial problem in 2013, when there are now over $2 TRILLION of WMPs outstanding.  This relatively new revelation, coupled with continued weakness in Chinese growth numbers, has threatened to bring the world’s economic engine to a grinding halt.

1.  The Almighty Dollar:  Last but never least we have the recent activities of Ben Bernanke and the US Federal Reserve System.  For the past two years, the Fed has embarked on a novel policy of “quantitative easing,” which essentially means that the Fed purchases long-term US Treasury debt at above market valuations in order to push more cash into the financial system.  There is substantial debate about what economic effects, if any, that this strategy produces; however, what is clear is that the global financial markets had come to believe that quantitative easing was going to be around for a long time – maybe forever.  As a result, investors, companies and banks rushed to issue large amounts of dollar denominated debt with the expectation that they would easily be able to repay the debt with newly printed dollars in the future.  This investment thesis makes sense so long as the supply of new dollars continues to be large and persistent.  Last week, however, the Fed announced that it would likely begin slowing quantitative easing by the end of this year and halting altogether by the middle of 2014.  That announcement sent shock waves through the dollar system, as many investors awoke to the reality that they would have to repay their dollar obligations with money generated from operating activities, rather than just new money printed by the Fed.  Suddenly, the large amounts of new debt seemed imminently more daunting and the prospect of holding cash imminently more attractive.  For now, this cash hoarding activity has mostly hurt emerging markets, who have seen massive outflows of capital as American investors begin exchanging their foreign currencies for dollars.  But the damage is also seeping into riskier and longer term American assets: high yield debt (“junk bonds”) have seen spreads widen this week and mortgage rates have backed up to almost 4.5%.  The rapidity with which these rates have moved indicates how fragile the system currently is, and it might just be waiting for the right trigger to send everyone scrambling for cash and setting off another financial panic.  The fact that this is happening at the same time as all the previously outlined global events makes for a very perilous situation.

So, what does this all mean for student loan borrowers?  More than anything else it means don't underestimate the value of cash savings.  We're going to continue to monitor these developments to see if there will be an imminent spike in the demand for dollars, but in the meantime we would encourage borrowers to think twice before using their free cash to prepay their outstanding loans.

Is the Federal Student Loan Program Really Profitable?! No, no it is not.

Again this weekend we saw articles published declaring that the Federal government was making “obscene profits” through the Federal student loan program.  This assertion is based upon the forecast published by the Congressional Budget Office that estimated the Federal government would record profits in excess of $50B on its loan portfolio – making it more profitable than Exxon Mobil.  As an individual who works and reviews the Federal student loan portfolio every day, I find these assertions a little bizarre because the Federal student loan program is not making money, it is losing money.  A lot of money.  In this post, I will outline how faulty accounting creates the illusion of profits in the student loan portfolio by reviewing the actual cash flow data within the Federal loan portfolio.

The disparity between CBO forecasts and the reality of the Federal student loan pool is a difference between non-cash accounting and real cash flow.  In the case of student loans, this is the difference between a loan that is in deferment and accruing interest versus a loan that is in repayment and is actually making cash payments.  Currently, the Federal government does not make a distinction between the two: a loan that has never made a payment and accrued interest for five years is considered equally profitable as a loan that has made full payments over the same five year period.  To demonstrate how big of an issue this is, let’s turn once again to the Sallie Mae asset backed securities data (I prefer Sallie Mae data because it is audited independently and any faulty accounting comes with legal liability to Sallie Mae and her shareholders).  

The figure above is a summary of several Sallie Mae student loan trusts.  Let me quickly review the data that I am summarizing.  First, we start with the “Pool Balance”, which is the total outstanding balance of all the loans in the trust.  In the case of the SLM 2010_2 trust, there are ~130,000 loans with a total notional value of ~$525 million.  The “WAC” is the “Weighted Average Coupon” and represents the average interest rate on the loans in the portfolio.  Multiplying these two figures together produces the “Implied Interest”, which represents the contractual interest that accrues on the loan pool each year.  Notably, these are all purely accounting figures and do not represent the actual cash flows within the portfolio.  

We start seeing the actual cash flows from the portfolio as we move down to Payment Data.  “Borrower Interest” represents actual cash interest payments made by borrowers against their loans.  “Guarantor Interest” represents cash interest payments made by the Department of Education in place of students who defaulted on their loans, and “Other Interest” represents several other relatively small payments made to reconcile interest payments.  The sum of these three categories represents the “Cash Interest” paid by the portfolio of loans.  Next, “Negative Amortization” represents the non-cash interest that has accrued on outstanding loans that are in some form of deferment or forbearance – that is, loans that are accruing interest but not making any actual cash payments.  The sum of these figures is the “Total Interest”, which reconciles (approximately) with the Implied Interest we previously calculated.  

There are a couple things that immediately stick out in this data.  First, of all the interest that is accruing in the loan pool only half of it is being paid in cash, while the remainder is non-cash negative amortization.  This is not necessarily disastrous for a student loan portfolio as every loan goes through a negative amortization period while the borrower is in school.  What is alarming about the Federal loan portfolio is that this negative amortization trend continues even after students are graduating: in the 2010_2 portfolio less than 6% of the portfolio is still in school but 50% of the interest payments are non-cash.  The problem is even more revealing in older portfolios like the 2006_3 trust, which is comprised of loans that were made to borrowers who were students at least seven years ago.  In the 2006_3 pool less than 2% of the loans are still in school, and yet nearly 60% of the interest payments are non-cash negative amortization!  

And what about those individuals who are making payments; those filed under “Current” loan status?  First, they make up just 50% of the total loan pool – meaning that half of all borrowers in the Federal loan portfolio are not current on their obligations.  Second, there are some alarming trends even in these “successful” borrowers.  Notably, the introduction of Income Based Repayment and other partial payment programs means that borrowers can stay “Current” on their obligations but still be making payments that are less than the interest accruing on their loans.  We can see evidence of this trend in the “Return” column of the Loan Status block.  This figure represents the Cash Interest amount divided by the outstanding amount of Current loans.  If each current borrower were making full payments on their obligations, then this figure would roughly equal the WAC on the total loan portfolio; if this figure is meaningfully less than the WAC, then that means that more Current borrowers are making only partial payments and still accruing interest on their loans.  What we see is that the Current borrowers in the older loan pools (from 2008 and 2006) are making full or near full payments on their obligations; however, Current borrowers on newer loans (2010) are not making anything close to full payments.  In fact, only 70% of the interest accruing on Current loans is being paid in cash, the other 30% is accruing as negative amortization.  So, for the 2010_2 pool of loans, just 37% of borrowers are Current and just 70% of those borrowers are making full interest payments on their loans – to say nothing about actually repaying the principal balance.

So, to return to our initial question, is the Federal loan pool really generating a profit?  One way to answer that question would be to look at the Cash Interest Return; that is, the total Cash Interest divided by the Pool Balance.  We see that the Cash Interest Return is hovering somewhere around 2.0% for these loan pools.  We can compare that to the Treasury’s ten year borrowing rate, which currently sits at a historic low of 2.2%.  At this point you might ask yourself: If the Treasury is borrowing at 2.2% and only getting 2.0% in return, then how are they making a profit?  The reality is that the Federal student loan portfolio is producing accounting profits but real losses. 

Google X: Let's Start Investing in Proven Innovators

Business Week recently published an amazing article about Google’s advanced research and development arm: Google X.  Google X is the successor to the Los Alamos labs of our grandparent’s generation, the Xerox PARC’s of the 1990’s and the NASA laboratories before the budget cuts of the last decade.  Google X is working on some pretty incredible and transformative projects: wearable computers (Google Glass), the first self-driving car, advanced nuclear reactors and some next-generation wind turbines.  The laboratory is led by the best and brightest that Google can find, including their co-founder and former CEO Sergey Brin.  Google brings these bright minds together and provides them with the resources and inspiration needed to drive innovation, and in return Google retains the intellectual property rights to their creations.  In a period where America is starved for innovation and questions about economic leadership are abound, it seems that there would be few better places to invest our resources than in R&D efforts at places like Google X.  So, how much is Google spending each year to achieve some of their truly inspiring results?  According to their annual report, Google spent just $6.8 billion on total R&D in 2012.  For context, that compares to the $140.8 billion spent by the Federal government on research and development.  So, what if there was a way to provide Google X with similar financial resources as the Federal government? What if we were able to provide Google X with a $50.0 billion annual R&D budget?

David Einhorn, the managing partner of the hedge fund Greenlight Capital, recently gave a presentation supporting the idea that Apple should issue large amounts of preferred stock in order to return cash to shareholders.  Einhorn is famous on Wall Street for his out-of-the-box and often contrarian investment picks, which are usually supported by an excruciatingly rigorous analysis and PowerPoint presentation.  With Apple, Einhorn argues that there is an enormous demand for “safe assets” given the great level of uncertainty in the markets, and that preferred shares issued by an enormous and well-respected multination corporation such as Apple could be as appealing, if not more appealing, to investors than buying ever increasing amounts of sovereign debt.  If investors are willing to turn over their savings to the Treasury, which has a dubious track record of producing any material commodity of significant value, then surely they would be willing to lend their savings to the corporation that has produced the iPod, iTunes, PowerBook, iPad and iPhone (maybe iTV?!)?  Einhorn goes on to say that Apple could use the proceeds from issuing these “iPrefs” in order to fund a dividend to common shareholders or other financial engineering approaches to enhance shareholder value.  But what if Apple, or other companies, didn’t use that money for financial engineering, but rather used it for actual engineering?

What if Google issued $50 billion worth of iPrefs each year in order to fund its R&D efforts at Google X?  Each iPref would pay a quarterly non-cash dividend of one share of Google common stock into perpetuity.  The value of the iPref would be determined by the expected future value of Google’s common stock.  Therefore, if the research work at Google X produced products that were commercially successful, then the iPrefs would receive a return on investment from their common shares.  In the interim, iPref investors would receive a steady dividend payment in the form of Google shares, which investors could then sell for cash on the market.  For investors who wanted a fixed cash return, rather than stock, they could simply enter into futures contracts with a broker: the investor would agree to sell the shares they received from their iPref dividends each quarter for a set period of time in exchange for a fixed dollar amount.  Based on current share prices and assuming a 5.0% dividend yield, my estimation is that issuing $50 billion in iPrefs would dilute Google’s common shareholders by less than 0.9% each year.  In other words, if Google X’s research projects were able to increase Google’s corporate profits by more than 0.9% annually, then both common and iPref investors would receive a positive return on investment. 

Why would an investor prefer an iPref instead of either a normal Google share or a bond issued by Google?  For starters, iPrefs would have no contractual default risk, which provides investors with certainty that their investment will not get locked up in bankruptcy court if Google ever ran into financial distress.  Secondly, the promise of new common share dividends into perpetuity means that the iPref investor will gradually accrue a larger ownership stake in the company, which would allow the investor to exert influence on the management of the company in the case that it was under-performing.  If the investor only owned common stock, then they would have to buy additional shares with additional investment in order to increase their ownership and influence.  Finally, the promise of share dividends into perpetuity would provide greater stability in the price of iPrefs relative to the underlying common stock, which would make them a superior store of value.

Most importantly, investors would seek Google (or Apple, or Microsoft, or Exon Mobil, or Berkshire Hathaway, or General Electric, or IBM, or Pfizer) iPrefs because their value is tied to Google’s ability to create and deliver products and services that consumers value.  Using iPrefs to transfer enormous amounts of our financial resources to these enterprises would allow them to take on much larger problems in order to develop more comprehensive solutions over much longer time-frames.  How quickly could Google field a self-driving car if it spent a $2.5 billion a year to have an additional 10,000 employees working on the project worldwide (Google has a total of 20,000 R&D employees today)? 

For a very long time we have been using financial innovation to promote unproductive economic activities, particularly in the higher education space.  Surely it’s about time to start reversing that trend.